Chapter 14 Assessing the Value of IT

Traditional Financial Approaches  ROI – Return on Investments Each area is considered an investment center ROI is calculated as net earnings from operations (earnings after deducting the depreciation expense but before deducting interest expense) divided by net assets (defined as total assets less goodwill, other intangible assets and current liabilities)

Approaches continued  Residual income Similar to economist’s measure of excess profit Difference between a division’s (or other activity) reported operating income and the financial opportunity cost of the division’s investment base Residual income measure will always be increased by investments earning rates of return above cost of capital

Approaches continued  Economic Value Added (EVA) – created in early 1990 Uses recent developments in corporate finance, especially the capital asset pricing model, to identify the cost of capital for a specific division or business unit Attempts to remove distortions to the investment decision (such as intangibles such as intellectual property, R&D, customer, brand and development

Approaches continued  Discounted Cash Flow Analysis Referred to as Net Present Value (NPV) Permits firm to choose between alternative investment opportunities to advance market value of the firm Developed as a method for evaluating projects based on their measurable cash flows

News Ways for Approaches  Future strategic options (cost savings, new products/services and markets)  Use Call option – option to buy an asset by paying a given amount on or before a certain point in time

New continued  Real option – invest or don’t invest Look at interest income that can be earned on the investment funds during the deferral period Decision maker’s ability to react to changing uncertain conditions during deferral period by altering investment decision to firm’s benefit  Decision Tree Analysis – revision of strategies and operations under uncertainty

New Continued  Oracle Corporation’s method Create committee of stakeholders affected by IT investment Define intangible benefits of IT investment (more flexible & efficient budgeting, improved decision analysis, improved responsiveness, etc.) Define intangible risks of IT investment (slow response to system change, risk of poor integration with existing systems, etc.)

New continued Establish weights to the relative importance of the tangible benefits (financial result), the intangible benefits, and the intangible risks of the investment Estimate on a scale of zero to five the likelihood of each benefit and risk being observed Multiply each likelihood estimate by the weight established for that factor and add up the products –greatest sum is the preferred alternative

Portfolio of IT Investment Projects  Society of Information Management International Working Group emphasizes the need for organizations to adopt a portfolio management process in assessing and managing their IT landscapes Ensure that IT investment proposals are understood in terms of expected business outcomes, the efforts needed to reach those outcomes, and the risks involved in achieving the outcomes

Portfolio continued Ensure that IT investment swill advance the value of the firm Ensure that the risks associated with IT investments are in line with the business’s acceptable risk profile Ensure that IT investments are aligned with business strategies

Trigeorgis’ approach  The objective of value maximization refers to a broad measure of Net Present Value  Strategic NPV = Traditional NPV of expected cash flows + Value of operating options from flexible management + Investment interaction effects

Approach continued  Strategic management of investments requires the management of a collection (or portfolio) of future investment opportunities and options  Appropriate control targets are necessary for the effective implementation of a value- maximizing (strategic NPV) approach

3 Phases of Managing IT Portfolio  Evaluation & Planning Perception of market conditions and interdependencies Options-based strategic planning and control processes: strategic NPV’s of IT investments  Control Design optimal control processes

Phases continued  Active management Revisions and management of investment portfolio

Activity-Based Measures  Activity-based costing (ABC) – methodology that measures the cost and performance of activities, resources and cost objects. Resources are assigned to activities, and then activities are assigned to cost objects based on their use

Measures continued  Activity-based management (ABM) – a discipline that focuses on the management of activities as the route to improving the value received by the customer and the profit achieved by providing this value. This discipline includes cost driver analysis, activity analysis, and performance measurement. Uses ABC as major source of information.

Study  Studies show that 20 percent of all customers provide virtually all of the profits of a company  Another 60 percent break evan  Remaining 20 percent only reduce the bottom line

Total Cost  Total Cost of Ownership (TCO) implies that the acquisition cost of materials is only a portion of the true cost of a product or process  Total Benefit of Ownership (TBO) considers the benefits of competing products or processes instead of just focusing on their individual costs – judges the merits of the added benefits against the higher TCO for 2 competing products

TCO analysis  Provide predictable costs and level budgets  Determine which IT resources can be applied to the firm’s core mission  How to determine the current costs and services of IT operations  How to increase service levels at an affordable cost

TCO analysis continued  How to track or recognize actual on-going IT costs  How to find a cost-effective way of improving IT expertise  How to determine the most effective implementation strategy to improve effective and efficient delivery of IT services

Total Value of Ownership  TVO – 3 differentiating features IT and business management must work together The firm needs to move from a pure cost center perspective, where the TCO approach is a best practice, to one emphasizing value creation (a profit center or investment center perspective) Managers must evaluate and manage a collection or portfolio of projects

Competitive Advantage  Methods need to be used to help competitive advantages  Use an IT-leveraged path to competitiveness  Follow 3-step plan Business outcome wanted Business process IT enabler